The Fat Pitch

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Thursday, May 24, 2018

Summary: The conventional wisdom is that "healthy breadth" is necessarily bullish. This sounds intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market, but it is empirically false. Equities can continue to move higher when breadth is healthy, but new highs in the advance-decline line or in the small cap index have also preceded drops of 10, 20 or even 50% in the equity market.

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The conventional wisdom is that "healthy breadth" leads to higher equity prices. This sounds intuitively correct: a broader foundation - where more stocks are ticking higher - should equal a more solid market. Conversely, a narrowing market should be a warning of a likely market top.

But it is empirically false. Consider some recent research into this issue.

The Russell small cap index (RUT) has been making new highs even as the large cap indices have not. Because there are four times as many stocks in RUT as in SPX, many infer that breadth is broadening and that this must be bullish for all equities. "When the troops lead, the generals will follow."

Yet, as Mark Hulbert points out, small caps have peaked after the major stock indices in more than half of the 29 bull markets since 1926. If the conventional wisdom was correct, small caps should lead by peaking before the major indices, but this happened only a third of the time (Mark's article is here).

Sunday, May 20, 2018

Summary: Equities are 2-5% higher so far in May, trying to add to their small gains from April and put behind a rough winter. This week, small caps closed at a new all-time high (ATH) and NDX broke to a 7 week high near its March ATH. This is constructive for the broader market. But new uptrends are defined by persistent strength; it's time for large caps to reveal the true character of this market.

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US equities fell slightly last week. SPX and DJIA lost about 0.5%. But May, so far, is tracking positive. Large caps are up 2.5%, tech stocks are up 4% and small caps are up more than 5%. The volatility index, Vix, has been crushed. Enlarge any chart by clicking on it.

Friday, May 18, 2018

Summary: Demographics is a key driver of economic growth (and, thus, the stock market). Many investors fret over the aging of the Boomer generation.

But the Millennial and Gen X birth cohorts are almost twice as large as the Boomers. Behind the Millennials is Gen Z, a group almost as large as the Boomers. The mid-point of these three generational groups does not enter retirement age until 2055. This prime working age group heavily consumes housing and other goods as they pass through their reproductive and household formation years. "The movement of these younger cohorts into the prime working age is a key economic story in coming years."

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Starting around the year 2000, many investors began obsessing over the aging demographic profile in the United States. The concern seemed reasonable. The working age population in Japan had peaked in 1995, 5 years after the Nikkei stock index. The stock market had halved by 2000 as the working population declined (by 13% from 1995 to 2018). Enlarge any chart by clicking on it.

Wednesday, May 16, 2018

Summary: Fund managers came into 2018 very bullish equities. Cash levels had fallen to the lowest level in 4 years. Allocations to global equities had risen to the highest level in nearly 3 years. Bond allocations were at a 4 year low. Our view at the time was that "this is a headwind to further gains" in equities. That post is here.

Since then, global equity allocations have fallen and cash balances have risen. Investors are no longer at a bullish extreme, although the equity correction has not (yet) made them outright fearful.

In the past 9 months, US equities have outperformed Europe by 6% and the rest the world by 5%. Despite this, fund managers remain underweight the US. US equities should continue to outperform their global peers on a relative basis.

Fund managers' inflation expectations are near a 14 year high; in the past, this has corresponded with a fall in US 10 year yields in the months ahead. Commodity allocations are at a 6 year high.

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Among the various ways of measuring investor sentiment, the Bank of America Merrill Lynch (BAML) survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets. Our sincere gratitude to BAML for the use of this data.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Overall: Relative to history, fund managers are overweight cash and commodities, underweight bonds and neutral equities. Enlarge any image by clicking on it.

Within equities, the US is significantly underweight while Europe, Japan and emerging markets are all overweight.

A pure contrarian would overweight US equities relative to Europe and emerging markets and underweight cash.

Tuesday, May 8, 2018

Summary: Overall, corporate results in the first quarter were very good. S&P sales grew 10%, earnings rose 24% and profit margins expanded to a new all-time high of 11.6%.

Fundamentals are driving the stock market higher, not valuations: earnings during the past 1 year and 2 years have risen faster than the S&P index itself.

The outlook in 2018 looks solid right now: the consensus expects earnings to grow 19% this year. Rising energy prices and the new tax reform law are tailwinds.

Expectations for 9% earnings growth in 2019 will probably to be revised downwards; the substantial jump in margins this year is unlikely to be sustained, especially with labor and interest costs rising.

With the correction in equities over the past 3 months, valuations are back to their 25-year average. They are not cheap, but the excess from 2017 and early 2018 has been largely worked off. If investors once again become ebullient, there is room for valuations to expand.

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84% of the companies in the S&P 500 have released their first quarter (1Q18) financial reports. The headline numbers are very good. Here are the details:

SalesOverall quarterly sales are 10% higher than a year ago, the best sales growth in 6 years (since 2011). On a trailing 12-month basis (TTM), sales are 8% higher yoy (all financial data in this post is from S&P). Enlarge any image by clicking on it.